Net Interest Income (NII) vs Economic Value (EVE)

Net Interest Income – Earnings versus Economic Value.

The two elements used within bank ALM analysis are economic value and earnings. Why is earning emphasized more than value? What is wrong with value analysis?

In the ALM world we use two tools to illustrate the impact of interest rate changes.

a) Rate or reset gap focusing on the impact of interest rate changes on earning . Rate or reset gap buckets asset and liabilities based on the next rate reset window. A loan with five years to maturity but with a floating interest rate that will reset next month will get bucketed in the upto one month maturity bucket.

b) Price or maturity gap focusing on the impact of interest rate changes on share holder value. Price gap buckets assets and liabilities based on the residual contractual maturity. The same loan with 5 years to maturity mentioned above will get bucketed in the 5 year maturity window.

Let’s repeat this once again for emphasis. Rate or reset gap for earnings, price or maturity gap for balance sheet impact. Which one should you use? Which one of the above do bank board of directors and executive teams focus on?

Net interest income versus economic value

Figure 1 The ALM Earnings vs. Value framework

This is where our discussion begins to get interesting.

ALM – Rate or reset gap

The rate or reset gap analysis assumption assumes that with changes in interest rates you will be able to change the applicable reference rate on both your deposits as well as on your loans. While this may be possible in very liquid markets, in a number of emerging countries the balance of power continues to shift between banks and large depositors. Liquid markets tend to shrug rate re-pricing away as an accepted market norm. However in illiquid environments the balance of power continues to shift between large depositors and borrowers and the banking system.

While the assumption may not hold completely, it is generally taken as relevant and the analysis generated on the basis of this assumption is not questioned heavily in the board room.

The ALM reporting tool that we use for analyzing earnings using rate or reset gap is called Net Interest Income at Risk or NII at risk.

ALM – Price or Maturity gap

The core assumption behind price and maturity gap is a mark to market of both sides of the balance sheet using the new applicable reference rate. Fair market value of assets and liabilities based on the most recent changes in the interest rate environment.

Think about that for a second. Can you go back to a depositor and tell him that the 1,000 dollars that he had put in yesterday are now worth 900. The short answer is no. Even though the opportunity cost argument holds, most bank regulators and depositors will not look kindly upon such a practice.

But that is deposits. On the advances front a working capital/running finance/over draft facility that resets rates every month and has a year to maturity is classified in the annual bucket. In most markets even after you call the loan, the collection process may extend over a few years. From a liquidity point of view, the underlying assumption was that the amount in question would be repaid within a year. From a real world point of view, it may actually be a few years.

The only part of the bank’s balance sheet that can be truly fair valued are market related assets and liabilities. Publicly traded securities that the bank holds on the asset or liabilities side. Everything else is debatable and fair game. One could make the argument that in a due diligence situation, fair value analysis becomes important but that too is a function of the franchise of the bank being sold. Some acquisition teams may push aggressively on the MTM of listed and traded securities. Other may ignore the impact based on the materiality of the discount.

The ALM reporting tool that we use for analyzing economic value using price or maturity gap is called Market Value of Equity at Risk or MVE at risk. The report essentially using Duration gap analysis to mark to market the balance sheet. For this reasons sometimes MVE analysis is also known as DGAP analysis.

ALM – Earnings or economic value? Which one would you chose?

While regulatory and investor disclosures may require the bank to share and present both earnings and value impact, the primary focus of analysts, executive teams and bank boards is on earnings.

There is certainly a short term bias in analysis and the earnings presentation gives analysts as well as the management team the information they need to fine tune their forecasts. Compared to earnings sensitivity, Duration gap analysis (DGAP) is a more recent arrival. More importantly, the set of assumptions behind earnings analysis are less questionable than the assumptions used in the value analysis. The value analysis is still dissected but it is a thicker, bigger, rougher cut that is dependent on a few questionable assumptions that are difficult to defend in an ALCO session.

The earnings analysis is more fine tuned and is used more commonly. Let’s take a quick look at the reporting template and some of the calculations.

There is a single reference rate for all assets, irrespective of maturity buckets. Similarly there is a single reference rate for all liabilities, irrespective of maturity buckets. Rates are expected to rise by about 2% for all assets and liabilities.

Net interest income versus economic value – rate shock

Figure 3 Projected interest rate environment

Based on the information shared so far we do a simple calculation to determine the interest earned and expensed across maturity buckets for assets and liabilities. The results are produced below:

Figure 4 Net interest income results for base case

For each cell above we take the balance in the maturity bucket and multiply it with the reference rate. Our assumption is that the reference rate is applicable for the remaining part of the year. Whenever the reference rate changes, the underlying assumption would be that it would stay applicable for the next 12 months.

The formula used for calculating interest is:

The implementation in Excel is as follows:

Figure 5 Net interest income calculation mechanics for base case

To calculate the revised NII figure after the project rate rise has happened we change the relevant reference rate and recalculate interest income and expense figures using a slightly different formula.

Figure 6 Net Interest Income at Risk calculation mechanics for the base case

Because of the change in interest rate there has been a shift in net interest income. Despite the fact that rates rose, net interest income is projected to declined from 159 million to 136.5 million. Why is that?

The explanation is simple. When you look at the structure of the balance sheet you can see that assets are invested in relatively longer term and are relatively immune to changes in interest rates. However, liabilities are primarily concentrated in the shorter term and re-price much faster than assets. This balance sheet structure is known as a liability sensitive balance sheet. Liability sensitive because liabilities re-price faster than assets. When rates rise, as is in our case, a liability sensitive balance sheet will generate a declining trend in net interest income.

In our next post we will spend some more time on the interaction of gaps, asset and liability sensitivity and net interest income at risk trends under rising and declining interest rate environments.

The change in formula for interest income and expense now accounts for two rates. The old rate applicable for the first part of the year. And the new rate applicable for the remaining part of the current year. There is no change in calculation for the one year bucket since our analysis horizon is limited to one year.

For the 3 month bucket the relevant formula for calculating interest income or expense is:

D6 is the cell that links with the amount in the maturity bucket while C11 and C31 are the old and the new reference rates.

Similarly for the six month bucket:

E6 is the cell that links with the amount in the maturity bucket while c11 and c31 are the old and the new reference rates.

The Excel implementation is as under:

Net interest income versus economic value – calculations

Figure 7 Net interest income calculations for incorporating the impact of changing rates

The Net Interest Income at risk template quickly gives you a heads up on projected changes in your earnings outlook based on a change in the interest rate environment.

Given its simplicity and ease of use, the template is relatively simpler to explain to executive committee and board of directors members and after a few iterations of usage, interpreting results also becomes easier.

In our next post we take a more detailed look at the interaction of gaps, sensitivity and impact on earnings.

(This post is part III of a five part series on better understanding ALM strategies from a board of directors and executive committee members point of view).

About the authorJawwad Farid

Jawwad Farid has been building and implementing risk models and back office systems since August 1998. Working with clients on four continents he helps bankers, board members and regulators take a market relevant approach to risk management. He is the author of Models at Work and Option Greeks Primer, both published by Palgrave Macmillan.

Jawwad is a Fellow Society of Actuaries, (FSA, Schaumburg, IL), he holds an MBA from Columbia Business School and is a computer science graduate from (NUCES FAST). He is an adjunct faculty member at the SP Jain Global School of Management in Dubai and Singapore where he teaches Risk Management, Derivative Pricing and Entrepreneurship.